War in itself is inevitably brutal, taking both a physical and psychological toll on all that participate in it. However, what determines who lives and who dies? What determines who wins and loses? While the numbers of factors involved are truly infinite, it can be safe to say that any faction with a technologically superior force would tend to have a distinct advantage in pitched battles, and in the context of the overall war effort.
Ceradyne (CRDN) specializes in the development and production of advanced technical ceramics that is utilized in industries such as defense, oil & gas, solar and medical. Based upon market conditions and the application of several valuation methodologies, Ceradyne should be considered a buy, with an average margin of safety calculated at 19.05%.
To say that Ceradyne is yet another firm in the defense industry would be a stretch, as the application of ceramics by Ceradyne is numerous, ranging from lightweight ceramic armor for solider/vehicles, enhanced combat helmets, missile radomes, neutron absorbing materials, filters for oil & gas recovery and so on. The majority of their products, however, stem from the science of advanced technical ceramics. Ceramics in themselves are both hardy and resilient to time, as proven in the numerous artifacts uncovered in the earth located in museums throughout the world. These traits, however, are further enhanced via the application of aluminum oxide and other oxides, yielding a product that is tougher then steel, relatively light, capable of withstanding high temperatures, resistant to acids and capable of both insulating and conducting electricity.
Ceradyne, like all firms, faces a number of risks:
A. Revenues stemming from the U.S. government are based on budget allocations, strategic direction of foreign policies and level of conflicts. Operations in the Middle East have been drawn down considerably, and as such production will be affected accordingly.
B. Government contracts are awarded in open bidding processes and can be revoked or modified without penalty.
C. Government contracts can dictate specific qualities to be integrated into products without notice, which may hurt margins. For example, historically, the military has dictated body armor to be both lighter, yet more effective with each generation of product.
D. Energy applications are highly reliant upon government protection with respect to tariffs and subsidies.
On the other side of the coin, however, Ceradyne also enjoys a certain number of competitive advantages:
A. Ceradyne’s portfolio of products is diversified, serving a wide range of customers and industries.
B. Ceradyne has several long-term contracts with the U.S. government to provide them with ceramic armors, along with other key customers. As such, long-term goodwill and brand has been established.
C. The process of manufacturing advanced technical ceramics is complicated and strenuous, and as such, renders an economic moat due to not being easily replicated.
D. The firm is vertically integrated, owning both raw material sources and manufacturing capability.
As a result of the numerous applications possible from advanced ceramics, their major customers are diversified into a variety of sectors. The following chart demonstrates the approximate breakdown of sales by sector:
The following demonstrates sales in Q1 of 2012 vs. Q1 of 2011:
As one can see from the charts, approximately 36.6% of their sales are oriented towards the defensive industry. Thus, with the drawdown of the conflict in the Middle East, it should not come as a surprise that comparatively speaking, Q1 of 2012 generated $106.3 million in sales, a drawdown of approximately 30% from sales of $150.1 million in Q1 of 2011. Likewise, net income declined from $23.59 million, to $3.78 million for the same quarterly periods. Much of this decline was attributed to lower demands originating from defense and energy sectors. The causation of the former is apparent, but the cause of the latter is due to “continued pronounced slowdown of demand in the solar energy market due to a reduction of government subsidies… and a buildup of solar inventories.”
Looking forward, the firm expects body armor sales to rebound based upon scheduled deliverers. However, Ceradyne lowered its overall guidance for the year due to a cited decline in demand from the energy sector, and production orders from the military. Revenues are now forecasted at $540 to $565 million for the year, with earnings per share estimated to range between $1.40 to $1.65. Yet, in spite of the pessimistic revision, the firm remains optimistic as in early 2012, the firm initiated dividend payments, with a regular dividend established in May of $.15. As CEO and President Moskowitz simply stated, this “enhances shareholder value” and will continue as “we can afford it.” The overall strategic direction of the firm is apparent, as in 2010, Ceradyne announced their goal of achieving $1 billion in 2016 in revenues. To accomplish such a goal, Ceradyne must increase their revenues yearly by 15%. The key to the execution of such a plan is as follows:
“Our 'Ceradyne $1 billion' strategy will rely primarily on organic growth coupled with appropriate acquisitions. Our plans are to use the Company’s strong cash position to seek out acquisitions while at the same time balancing shareholder value efforts, such as our 2012 quarterly dividend initiation, stock buyback and growth-focused capital expenditures.”
The following charts serves as a comparative analysis of Ceradyne and its competitors, within the context of the defense industry.
The following charts and tables demonstrate the relative valuation of Ceradyne under eight different methods.
On one hand, the firm is quite liquid, well above industry standards, with less debt then their counterparts. However, the firm falls short under ROE / ROA metrics. In terms of profitability, the firm is about 4% more profitable then its competitors. The average price rendered from all the multiples is $30.05, which yields an upside potential of 19.05%. Ceradyne trades at a low 3.05x EV/EBITDA multiple, and is trading below book value under current prices. As the tables would further reveal, under the P/S and P/E valuation methodology, the firm is trading at a premium. However, when one utilizes enterprise values lest the revenue metric, and the P/B or P/CF metrics, the firm is trading at a significant discount.
The overall outlook of Ceradyne is quite positive. At current prices, the dividend yield of the firm is 2.38%, and the initiation of dividends to investors in itself signifies a commitment to shareholder value. In addition, Ceradyne is currently trading at a 17% discount from book value, another classic value signal. In terms of operations, the firm is quite aggressive in acquisitions, and is set upon achieving $1 billion in revenues by 2016. Acquisitions are not only in the defense sector, but as their portfolio of products would suggest, diversified across numerous sectors, as Ceradyne attempts to increase non-defense revenues. As such, under current market conditions, an investment into Ceradyne should be considered for investors looking to diversify their holdings.
Gurus Joel Greenblatt and Ken Fisher are currently holding Ceradyne in their portfolio.